How to Understand What Affects Mortgage Rates

Mortgage interest rates are influenced by marketplace activity and government monetary policy.

Mortgage rates affect the long-term cost to finance a home purchase. At the same time, interest rates represent risk for mortgage lenders. Lower rates are associated more often with low-risk borrowers whose stable and consistently healthy financial history makes default less likely than borrowers with bad credit history. Although borrower finances are an important determinant in the mortgage process, many economic and governmental factors also affect mortgage rates.

Inflation

Inflation is the upward change in prices over time that erodes purchasing power across the economy. Since inflation erodes the value of profits as well, mortgage lenders react by increasing mortgage lending rates to preserve the purchasing power of their returns. For example, if current mortgage rates average 6 percent and inflation increases by 2 percent, lenders try to counteract the 2 percent loss of purchasing power by increasing mortgage rates to preserve the value of the returns on mortgage loans.

Economic Growth

High levels of economic growth generate higher incomes, more investment and increased consumer spending. The expectations of economic stability drive prospective homeowners into the mortgage market. The increased demand for mortgages generates upward pressure on rates in reaction to the limited supply of loanable funds. The opposite is true during periods of slower economic growth in which spending, investment and income decrease, drawing potential homeowners away from the mortgage market. Consequently, the decrease in demand for mortgage borrowing places downward pressure on mortgage rates.

Monetary Policy

The Federal Reserve (the Fed) is the nation’s central banking authority and one of the key influences in the economy. Although the Fed does not directly set interest rates in the open marketplace, it does indirectly influence rates by adjusting the supply of money circulating the economy to achieve specific goals. If the Fed decides to increase the money supply, interest rates decrease. Conversely, interest rates increase if the Fed decreases the money supply. Either of these two Fed policy actions influences mortgage rates accordingly, which is why timing is important for home buyers.

10-Year Treasury Yield

Tying current mortgage rates to the 10-year Treasury yield helps mortgage lenders minimize the negative effects of economic cycles and interest rate changes. The yield on the 10-year Treasury is considered a benchmark of long-term interest rates by many lenders and financial institutions. This is important for mortgage lenders because mortgage loans are long-term investments. To keep the loan as profitable as possible, lenders peg their lending rates to the 10-Year Treasury bond yield to help stave off the negative effects of interest rate changes.

Housing Market

Developments in the housing market work in concert with macroeconomic events that influence mortgage rates. The housing market can be illustrated with the basic interaction between supply and demand. Any expected or unexpected change in either supply or demand for housing influences mortgage rates. For example, unemployment and inflation diminish the demand for mortgages and place downward pressure on mortgage rates. Similarly, builders that go out of business or merge with other builders may influence the supply of housing. In a scenario where less housing is constructed from fewer builders and more homes are for sale because of foreclosure, the supply of housing increases, driving rates lower to attract buyers.

About the Author

Gilberto Fuentes draws on his experience in financial services to develop copy for websites in the United States, United Kingdom and Latin America. His work has been published in the online editions of the "San Francisco Chronicle" and the "Houston Chronicle." Fuentes lives in New York and holds a dual Bachelor of Arts in English and economics.